Suppose that your local government, threatened by bankruptcy, decides to tax the interest income on its...

Suppose that your local government, threatened by bankruptcy, decides to tax the interest income on its own bonds as part of an effort to rectify its budgetary woes. If bondholders care about their after-tax returns, what would you expect to happen to the prices of local municipal bonds? To their yields? Explain

Expert Solution

It has been stated that local government, threatened by bankruptcy, has decided to tax the interest income on its own bonds.

The bondholder care about the after-tax returns.

Imposition of tax on interest income from bonds will reduce the after tax returns of the bondholders.

As bondholders are sensitive to the after tax return, this decrease in the after-tax return will compel the bondholders to decrease their demand for bonds.

Thus, the demand for local municipal bonds will decrease.

Given the supply of local municipal bonds, this decrease in the demand for local municipal bonds will lead to fall in the price of local municipal bonds.

Thus,

The prices of local municipal bonds will decrease.

Price of bonds and yield of bond moves in opposite direction.

A decrease in price of bonds results in an increase in yield from bonds and vice-versa.

The price of municipal bonds will decrease.

So,

The yield on local municipal bonds will increase.

Rahul Sunny answered 1 year ago

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